As investors, we all want an edge. So why make this difficult? Investors who make the most money over the long term buy and hold common stocks.

At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who make even more buy and hold small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can roll the dice on a small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Sort of. You see, I recently had the pleasure of chatting with Motley Fool founder Tom Gardner -- a guy who has made a career out of digging up well-run small companies ahead of Wall Street, and who never shuts up about it.

And you know what? I'm beginning to suspect that Tom is onto something, and that the team he assembled at Motley Fool Hidden Gems really is piecing together a portfolio of small companies I probably couldn't have found on my own. What's their secret? I think it's that these guys focus on fundamentals, while I tend to get wowed by story.

More specifically, they insist on a few important criteria when searching for great small companies:

  • Solid management with significant stakes
  • Great, sustainable businesses
  • Dominant positions in niche markets
  • Sterling balance sheets
  • Strong free cash flow

I know it's hard to imagine now, but many of these same traits gave investors the courage to follow a young Howard Schultz into Starbucks (Nasdaq: SBUX), a longtime Motley Fool favorite. The same goes for Sam Walton and Wal-Mart (NYSE: WMT) back in the 1970s. Both were pretty decent investments.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own names like Starbucks and Wal-Mart? And you're right. That's why it's so hard to beat the pros with familiar stocks like those when they're hot; if they're really all that, they're going to cost you.

But what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not necessarily well-known companies. There's a difference.

For example, flashy tech outfits with sexy names like Level 3 Communications  (Nasdaq: LVLT) and Tellabs (Nasdaq: TLAB) are familiar tickers long before we figure out what they actually do. Companies like Southwest Airlines (NYSE: LUV), on the other hand, have strong regional and even national footprints long before they hit Wall Street's radar.

Need more proof?
Check out my buddy Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of story stocks like Sirius Satellite Radio (Nasdaq: SIRI). In fact, I'm willing to bet that Apple is the only stock on the list you've ever heard from your broker. Though you might recognize a few more of the companies from "real life."

You see, there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these gems. That's precisely how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, outperforming with a mutual fund is a crapshoot at best -- a long shot. That's why I'm a fan of exchange-traded funds (ETFs) -- you get broad exposure to the entire group without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth (IJT) and Value (IJS) indexes.

What to do now
If you ask me, a strategy of holding these ETFs and scaling gradually into the stocks you hear about each month in the Hidden Gems small-cap newsletter is a winner. After all, you want to be diversified, but sooner or later, you also want exposure to a few small businesses with massive potential.

Meanwhile, I promise to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 26.4% since the newsletter's inception, compared with 6.2% if you'd invested in the S&P 500 for the same period. That's a serious edge.

If you're interested, you can try the complete Hidden Gems service for 30 days free. That way, you can take up Wall Street's worst-kept secret directly with the team of analysts and check out every current and past recommendation (including the top five picks for new money right now). You can even download all back issues and reports. Of course, there's no obligation to subscribe. To learn more, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. Starbucks is a Stock Advisor pick. Wal-Mart is an Inside Value pick. You can view all Hidden Gems picks instantly with your free trial. The Motley Fool has a full disclosure policy.